When correlation strikes

Here is a great example of the flaw in risk models that rely on historical correlations. Using data from Credit Suisse on leveraged loans and distressed leveraged loans, we compute the correlation of the loan markets to the S&P500 since 1997.





Correlation of this portion of the credit markets to the equity markets has generally been unstable, registering both positive and negative measures over the past decade. But in a real financial crisis we know that correlations rise, as evidenced by the loan markets. The spike in 2008 was significant, reaching correlation of 0.8 between markets that traditionally have been loosely correlated or even anti-correlated. This was in fact the case with other credit markets as well, including corporate bonds and ABS.

Now consider capital and risk models (such as the Basle Accord) that are based on the ability to "diversify" across exposures. Supported by academicians, regulators, rating agencies, and practicing risk managers alike, these models are intellectually elegant and have proved profitable by conveniently reducing "expected" losses. This spawned what amounts to a whole industry of these participants, all with a vested interest in maintaining support for correlation based capital models.

One notorious example of such approach has been the assumption that pools of residential mortgages spread geographically across the US are sufficiently "diversified". Property values under this model (and based on some historical data) would therefore not be expected to drop simultaneously across the country. The beauty of this approach is that it makes the pools significantly "safer", even as individual loans remain risky, lowering expected loss of such pools, and allowing a large senior component to be rated AAA. As we now know, these misguided correlation assumptions have created a clear path to under-capitalization, which is where the financial system found itself in the midst of 2008.

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Asset managers get reprieve from FAS167

As we discussed earlier, FAS 167 would become a nightmare for asset managers. Instead of providing more transparency, the FAS167 reporting would actually end up with less.

E&Y: As written, Statement 167 may result in asset managers consolidating many hedge funds, private equity funds and other investment funds that they manage. Some financial statement preparers and users have indicated that consolidation of funds by asset managers will result in less meaningful financial statements

FASB recently decided to defer hitting asset managers with 167 until these consolidation issues are addressed.

E&Y: At the 11 November meeting, the FASB voted to expose for comment an amendment that would defer the application of Statement 167 for a limited number of entities (principally mutual funds, private equity funds and hedge funds) until the completion of the joint FASB/IASB project on consolidation accounting.

It's good to know that when it comes to the post-crisis regulation (including accounting/transparency regulation)at least some folks are being rational about it.

Update: Looks like CLO/CDO managers are not on the list of entities that would get the FAS167 deferral. That means they would need to consolidate billions in CLOs they manage onto their management company financials.


FAS167 for Asset Managers

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Implied Real Rate tells a story of loose monetary policy and asset bubbles

There are numerous ways to measure how easy the monetary policy is at any particular time. Quantitative easing aside, one can look at the overnight rates as the simplest measure of stimulus levels. The Fed Funds rate fluctuating between 12 and 25 basis points feels sort of accommodative.

Of course a better measure is the real rate, which is the nominal overnight rate less inflation. The lower the real rate the more stimulus is being provided. Unfortunately inflation in the form of CPI releases is a backwards looking indicator. Any monetary policy is meant to set the stage for the next few years and should be more reliant on forward looking indicators of inflation. One such indicator is the inflation rate implied from TIPS. There are clearly issues with both TIPS and the CPI measure itself, but the implied inflation measure gives a decent forward looking indicator implied by the markets.

Many economists view low real rates that exist today as restrictive because of tighter credit in the current environment. However the market implied inflation rate already takes into account the current and the expected credit conditions. Therefore the Implied Real Rate is in fact a more holistic indicator of how loose the monetary policy really is as viewed by the markets.

Let's define the Implied Real Rate as follows:

Implied Real Rate = (Fed Funds Effective rate) - (inflation rate implied by the 10-year TIPS).

The Implied Real Rate is now at about -2%, the lowest level since TIPS have been first issued. That certainly feels quite accommodative, but let's compare the situation to the last cycle. In particular, let's look at how accommodative policy impacted asset levels - here we use S&P500. The last big drop in the Implied Real Rate was back in the 2002 - 2004 period, which launched the famous liquidity driven asset bubble.





Here is what the measure looks like right now.





Given the similarities, is the accommodative monetary policy that is currently in place setting us up for another crisis? Is the Fed behind the curve? Many argue that there will be time to take the liquidity out. By then however it may be too late:

From HSBC:
The remarkable thing about such liquidity-driven asset bubbles is their long-cycles, underlining the eventual potency of loose monetary policy. Also, successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble – and, more often than not, policy-makers are reluctant to step up for fear of bringing down the house.

To illustrate that effect, in 2004 the monetary policy did in fact begin to gradually get tighter, as the Implied Real Rate began to rise. But as HSBC points out above, this gradual tightening is (and in fact was) ineffective, and asset prices continued to rise unabated.




Mr. Bernanke, maybe it's time for action.

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Corporate lending ready to take off - just need the borrowers

Banks are ready to increase lending to corporations and will attempt to ramp their lending significantly in 2010. Here are the reasons:

1. Since the beginning of the year, bank commercial and industrial loan exposure has dropped by 14%, while real estate loan exposure has decreased by only 2%. To the extent they can, banks will rotate out of real estate loans and into corporate loans.

2. At this stage, real estate linked loans constitute some 32% of the balance sheet, while corporate loans are under 12%.

3. As the chart below shows, commercial and industrial loans as percentage of the total assets have dropped quickly. Bankers have demonstrated to their credit departments that corporate loan exposure can in fact be reduced when need be (large corporate loans can trade fairly actively).





4. The following chart from the Fed shows the end to tightening of lending standards to companies.





5. As capital markets stabilize, the bid-ask spreads become tighter, reducing profitability of market making activities. 2010 budgets will need to shift more into lending.

What is less certain is how much demand will exist for corporate loans. So far the demand for corporate loans has been weak.





The stronger companies have been able to tap the bond markets, avoiding some of the loan covenants. Other firms either have cash or simply have no major expansion plans. Given the level of unemployment, corporations continue to be cautious on expansion plans or capital projects. To the extent possible (with 08 fresh on their minds) firms will avoid increasing their leverage. The one key area where banks will be able to help is in inventory financing as corporations try to rebuild depleted inventories (see chart below).





It's not at all clear however how soon the inventory rebuilding will begin. Corporate lending will be ready for business, but will there be takers?

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Hedge fund liquidity may prove fleeting

This chart from Hedgebay shows the full history of secondary hedge fund transactions (that Hedgebay has in their database). The discount, which seems to be permanent for now indicates the liquidity premium one would demand to go into a fund that is presumably locked (via a lock-up, a gate, or a general redemption suspension).




Some of the discount may be valuation uncertainties, but with all the scrutiny on hedge funds these days, most valuation uncertainties would have been vetted with third parties. If they haven't been, no one would buy such fund even at a 10-15% discount.

Such liquidity premium means that funds who provide the best liquidity terms (within their strategy category) will be able to raise more capital than those who have long lock-ups and sidepockets.

It's somewhat of a dangerous game because this may create an asset-liability mismatch. That is funds will offer unrealistic liquidity terms just to get the capital in the door. As assets become fully priced and rates continue to stay low, hedge funds will be pressured to seek out less liquid strategies to squeeze out incremental returns. They may deploy leverage, making less liquid investments even more illiquid. The liquidity of the portfolio will become "mismatched" with the liquidity terms for redemptions (the liability side).

And when redemptions increase, funds will put up gates and we are back where we started. As much as institutions, particularly funds of funds seek the liquidity holy grail, these investments are not mutual funds, and the most "investor-friendly" liquidity terms may not provide the investor protection these institutions expect.

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IASB proposal for amortized cost and impairment

Currently if you are a bank, a loan you originated will be held at par on the books and accrue interest. The loan makes you one day's worth of interest less the funding cost - every day. No volatility. That is until one morning you walk in and find out that the coupon you've been accruing never came. Now you not only have to reverse out the amount accrued on that last coupon, but also have to take a provision against principal loss. This provision reverses the life-to-date interest income on the loan and then some. This "oops" approach to loan accounting is called the "incurred loss impairment method", and is standard under current accounting rules. As a bank you could be holding a bunch of option arms, and as long as they make the minimum payments you would keep them at par (in fact you would keep them above par to account for the "negative amortization"). That's how many smaller banks that were fine a couple of years ago, all of a sudden became undercapitalized/insolvent.

To address this issue, the International Accounting Standards Board (IASB) has proposed an alternative (see attached document). It's a portfolio approach that requires the lender to continuously project total expected losses. The expected losses are then amortized over the life of the portfolio and netted against interest income. For example if you project a 20% total principal loss on the portfolio over the next 5 years, you would be deducting 4% of the initial portfolio face value from the interest income going forward. It's a constant dollar amount taken out of interest income every year. That means if loans default at some constant rate, interest income will drop off, while the provision will stay constant, creating a possibility of net interest loss.

Here is a comparison of the current method with the "expected loss model":

IASB: Interest revenue that is recognised will reflect the allocation of expected credit losses over the life of the instrument. This is a better reflection of the ‘economic’ interest that the lender expects to earn from an asset over its life than today’s approach. Hence, it avoids inappropriate front-loading of interest revenue.

This approach becomes more problematic when the expectations for credit losses suddenly change. That may mean that the reserve has been "under-accrued", and IASB would say that you have to take that difference into P&L immediately. And this concept makes it the trickiest portion of the proposal.

IASB: Using the proposed impairment method, credit loss expectations are updated each period. Any changes to initial expectations of credit losses will be recognised immediately in P&L. This change could be an increase in expected losses, or a reduction (reversal) of past expected losses (including the initial expected loss estimate).

If one uses CDS spreads for example to imply credit loss expectations, this method amounts to a form of mark to market. It effectively means that rather than holding "banking book" loans at par (current methodology), banks would be required to take a mark to market hit amortized over the expected life of the portfolio. And that could be bad news for banks that are thinly capitalized - these reserve requirements may make them insolvent.

Expect a massive industry (and political) backlash against this accounting methodology going into effect. In addition, if IASB adopts this proposal, it may impact the convergence of the US GAAP and the IAS standards, which has been the ultimate industry goal in recent years.





SnapshotFIImpairment5November

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Lend more, but don't increase your leverage

How many times have you heard that banks have taken on way too much leverage. And that ended up causing the current crisis. Right? But no more. The US Congress is trying to put this into action. Under the "too big to fail" proposals, the largest banks should be prepared for higher capital requirements (thus lower leverage). The smaller banks are already significantly undercapitalized because of their real estate exposure and are trying to improve their capital standing before the FDIC shuts them down. They need to de-lever more by rebuilding their capital base.

So that's what banks have effectively done - they've deleveraged. The chart below shows the ratio of total loans and leases (commercial, industrial, real estate, consumer) to book equity for all the US chartered banks.



source: FRB


Banks have reduced that ratio since 08, keeping it fairly constant in the last 6 months. The overall bank leverage is now down, though maybe not as much as the regulators would like to see. Much of it was done through equity raises, retained earnings, loan sales, and reductions in lending. Looks like we are moving in the right direction, right?

But wait! Mr. Geithner now says banks have to lend more!

Bloomberg: U.S. Treasury Secretary Timothy Geithner is echoing billionaire investor Warren Buffett in telling banks “to take a chance again on the American economy.”


So far, his appeal is falling flat.

Banks are not listening because... maybe... they were told for the last 2 years to reduce leverage.

And Mr. Stiglitz, Columbia University economist adds that if the banks were taken over by the government, we could simply force them to increase their leverage by telling them to lend more.

“Bloomberg: If we had done the right thing, we would be able to have more influence over the banks,” Stiglitz told reporters at an economic conference in Shanghai Oct 31. “They would be lending and the economy would be stronger.”

Lend more, but be prepared for higher capital requirements. Take more risk, but don't increase your leverage. Extend more credit, but no "excessive lending". Which is it?

As the credit addicted US economy goes through it's withdrawal symptoms, is the answer really more credit? Certainly the US government thinks so and has shown an enormous commitment to credit expansion. But now it wants banks to follow along.

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A sociopath at the gate - Westgate that is

When one thinks of the word “sociopath”, a killer of some sort generally comes to mind. It’s someone who is completely devoid of emotion or empathy for others. Someone completely focused on his/her own needs with absolutely no regard for those around them. The definition in Wikipedia states that sociopath is often used as an alternative word for a psychopath to avoid confusion with the word “psychosis” (which is unrelated). The description is divided into two factors: “aggressive narcissism” and “socially deviant lifestyle”:

Factor1: Personality "Aggressive narcissism"

Glibness/superficial charm
Grandiose sense of self-worth
Pathological lying
Conning/manipulative
Lack of remorse or guilt
Shallow affect
Callous/lack of empathy
Failure to accept responsibility for own actions

Factor2: Case history "Socially deviant lifestyle"

Need for stimulation/proneness to boredom
Parasitic lifestyle
Poor behavioral control
Promiscuous sexual behavior
Lack of realistic, long-term goals
Impulsivity
Irresponsibility
Juvenile delinquency
Early behavior problems
Revocation of conditional release

Why are we discussing this in a financial blog you may ask? Well, it is estimated that about 1% of the population has this disorder. And the area of finance is particularly attractive for people with these special “talents”. Bernie Madoff is one of them, Marc Dreier is another. There are numerous others, and not all have such a high profile. One of them lived in a peaceful suburban community in Saddle River, NJ. His name was Jim Nicholson. Jim, in his early 40s, a father of 3 young boys, was married to Donna - his high school sweetheart. Jim coached the local little league team and was the pillar of his community. He also managed money in a hedge fund he created called Westgate Capital. He didn’t like to take in institutional money – instead he managed funds for his friends, his neighbors, and his family. His returns were rock solid and new funds just kept coming in (particularly from people closest to him).





These returns would be the envy of most money managers - steady and consistent. But it was all a fraud. It’s not clear when it became fraud, maybe 2003, maybe earlier. Investors figured this guy is not going anywhere, he's got 3 kids and is happily married. But after the Madoff news hit, many tried to redeem their money and Jim's ponzi scheme began to unravel. The check he sent to redeeming clients bounced. And the thing with the "perfect family" turned out to be, well, not so perfect after all. From LoHud.com:

James M. Nicholson, accused of running a fraudulent hedge fund, cheated on his wife with another woman for more than a year as he continued to bilk investors out of tens of millions of dollars, according to his wife's divorce papers. Donna A. Nicholson's divorce papers, a copy of which was obtained yesterday, provided details into her husband's extramarital affair and the effects of the criminal case on her and their three children.
...
He's accused of stealing an estimated $163 million from his clients since 2004 through his hedge fund business, Westgate Capital Management LLC in Pearl River and Manhattan.Donna Hostomsky and James Nicholson grew up in Haverstraw and were high school sweethearts. They married on Sept. 26, 1992, and lived in Stony Point before moving to Saddle River, N.J.
...
Donna Nicholson's divorce papers accuse her husband of adultery with Toronto investment trader Linda Boville, starting on Feb. 1, 2008. Donna Nicholson's papers state that her husband admitted having sexual relations with Boville in New York City, New Jersey, Florida, Las Vegas, Canada and "in other locations and at other times and places too numerous to account."
....
Donna Nicholson accuses her husband of extreme cruelty with the adultery and alleged crimes. She also says they have irreconcilable differences. She claims his arrest "led to the seizure of all our marital assets, leaving myself and my children penniless and without any means of support."
...
Nicholson came under scrutiny by Rockland investigators a few months ago after nearly $5 million in redemption checks to clients bounced, county District Attorney Thomas Zugibe has said.

Unlike Madoff however, Jim didn't feel like having an accountant, even an incompetent one that Madoff had. Why bother? Just come up with a fake name, get a PO box and an answering machine - and you got yourself an "accountant".

LoHud.com: He also has been accused of doctoring financial statements and setting up a phony Manhattan accounting firm that sent out fictitious statements telling investors they were making money. He is accused of using money obtained through new investors to pay off suspicious longtime investors. Nicholson is being held on $10 million bail in the Metropolitan Detention Center in Brooklyn.

As a true sociopath, Jim had to indulge himself any way he could:

LoHud.com: Documents show he bought an interest in a multimillion-dollar private jet and a $27 million oceanfront estate in Southampton. He also bought a condo at the Time-Warner Building in Manhattan valued at $8.5 million. He also owned a $4.75 million condo in Palm Beach, Fla.

For those who are interested in more gory detail on this sociopath (which is not covered well by the media), see the full complaint below. But the moral of the story is that sociopaths like Jim make it that much tougher for honest money managers to make it. That's right, there really are honest money managers out there.

As an investor, follow the 3 simple rules:
1. Watch those returns to make sure they are realistic (they have some semblance to what markets are doing and the strategy makes sense)
2. Make sure there is a real accountant there who does the audits and knows what she is doing.
3. And watch for signs of the sociopath


Comp 20911

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Steepening curve - the only logical outcome

Gradually but surely, the US treasury curve continues to steepen. In this environment it's simply inevitable. With the unemployment rate approaching a post Great Depression record, political pressure to keep pumping stimulus will be enormous.




The two ways to finance stimulus spending is via tax increases or by running government deficits. Tax increases however (including state taxes) will exacerbate unemployment further, forcing more budget deficits. The debt supply at the longer end of the curve will continue to grow as the Treasury tries to term out the massive short-term financing they are currently running.




At this stage this steepening seems to be the only logical outcome.

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Risk management wisdom from the math department

Want to learn about the future of risk management? NYU is on top of it - they know risk management is all about mathematics. They are offering a seminar called "Conference on the Future of Risk Management" organized by "The Mathematics in Finance Workshop" and the Courant Institute (the NYU math department).



But wait. The math department? Wasn't the reliance on mathematical models sometimes with little relevance to reality what got us here in the first place? Doesn't matter. NYU is just trying to recruit 2010 applicants for their mathematical finance program (applications have been down for some reason).

So who are the speakers/panelists for the program? Well, here is the list:

Ken Abbott, Morgan Stanley
Steve Allen, Courant Institute
Richard Bookstaber
Aaron Brown, AQR
Christine Cumming, New York Fed
Robert Engle, NYU Stern Business School
Petter Kolm, Courant Institute
William Morokoff, Standard & Poor's
Brian Peters, New York Fed
Lesley Rahl, Capital Market Risk Advisors
Matthew Richardson, NYU Stern Business School
Marc Saidenberg, New York Fed
Anurag Saksena, Freddie Mac
Til Schuermann, New York Fed

This list looks about the same as it did in 2007 for similar conferences. Many of these folks were in senior positions in the last few years. These positions had given them tremendous visibility into the madness that some areas of structured finance had become prior to the crisis. But they went on their speaking circuits, wrote their books, did their consulting work, and developed their VAR models. None of them had been vocal about the rising leverage, the ratings arbitrage and conflicts, the regulatory capital arbitrage, the loose monetary policy, and the mispricing of risk. And now they are here to teach people about risk management? The lesson one will learn from these folks is simple: stick with the status quo, don't rock the boat, "reinvent" yourself after the crisis, and watch your career take off - setting you up for another crisis.

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Sponsors' pain rankings

The chart below from Moody's takes a sober look at the performance of the largest LBO firms. It presents the percentages of LBO deals by sponsor that are either distressed or have defaulted. Cerberus with investments such as Chrysler and IAP Worldwide (IAP provides support services, particularly for the US government/military) seems to have 2/3 of it's LBO deals go bad. Apollo (with deals like Hexion, Berry Plastics, Linens 'N Things, and Harrah's) is not too far behind. KKR on the other hand has done quite well. The group of sponsors as a whole is at 40% (distressed and defaulted). Got to love all that leverage.





Moody's points out that on average LBO default rates are no higher than other corporations - except for the largest deals. Hence the result.

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Colleges struggle with "net tuition" revenue

If you are paying for a private college in the US, you know how painful it is to write that check (often over $20k) every semester. The chart below shows the maddening pace of tuition growth relative to inflation or even healthcare. CPI becomes meaningless for those who plan to put several kids through private colleges.


source: Wikipedia

Private college tuition went up again this year by 4.4% (College Board survey) - way above the CPI growth. So these schools must be rolling in cash, right? Apparently not. The number that colleges focus on is the "net tuition" - tuition revenue after scholarships and financial aid. Net tuition has been growing much slower than the "headline" tuition number (as the full payers subsidize those who can't pay) and is now on the decline. This is particularly the case for the less competitive schools in small towns and rural areas.

Moody's: We recently surveyed rated higher education institutions and found that a far larger proportion of private colleges are experiencing price resistance. These institutions tend to have limited financial resources and less ability to withstand a drop in revenues. The risk of rating downgrades is likely to remain elevated for this segment. Our survey focused on net tuition revenue projections for fiscal 2010, generally ending June 2010. Nearly 30% of private college respondents project a decline in total net tuition revenue, compared with just 9% in the prior year.

Historical and projected net tuition revenue - % of colleges expecting declines:


source: Moody's

The good news for those who can pay the full tuition is that private college admissions may become less competitive over time as colleges struggle to improve the "net tuition" revenue. We may also see more "consolidation" (to the extent such a thing is possible) among colleges (such as Barnard and Columbia as well as other schools in the 80s).

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Only the strongest survive (and thrive) in the CP markets

Money market funds continue to struggle to put cash to work , searching for product that would comply with pending new regulation, yet provide returns that are above treasury bills. The returns on money market funds continue to be pathetic - about 15-25 basis points annualized.

The better rated banking firms have taken notice of this demand. They now have a choice of funding themselves by borrowing from other banks or via the CP market. (Neither was really available on anything but the overnight basis in the second half of 08).


With the 3 month LIBOR hovering above 25 bp, CP funding is cheaper for banks that can get AA rating on the paper (see the CP yield curve below).





And banks are indeed taking advantage of it, issuing CP and selling it to guys like the Fidelity MM fund. That gives the larger/stronger banks a real advantage over the smaller ones. Community banks have to pay depositors 60 bp on checking accounts and over 105 bp on money market acccounts - and that's their key source of funds. The larger banks can fund themselves with CP at 20 bp. That's a significant competitive advantage.

The new issuance of CP has caused the amount of financials-issued commercial paper outstanding to spike,



source: FRB



driving up the overall CP notional.



source: Bloomberg


This new supply is easily absorbed by money market funds. The CP market has simply bifurcated into those who have the credit quality to issue paper and those who don't - there's little in between. With new regulation, money markets won't be able to buy much "tier-2" CP and there aren't other buyers out there. You are either "tier-1" or you are basically out of the market (some stronger "tier-2" can still place paper, but in limited amounts - maybe 5% of the total). For a while the Fed was buying CP via the CPFF program, but that's winding down:



source: FRB


The survivors in the CP market are some of the strongest institutions or institutionally sponsored ABCP programs. Everyone else has to look for other sources of funds.

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The bipolar nature of inflation expectations

Back in July we've discussed the tremendous uncertainty surrounding longer-term inflation expectations for the US. This is not an academic exercise. Getting it wrong could swing the US economy into a deflationary spiral (similar to Japan) at one extreme or a hyperinflationary environment on the other.

The chart below from the San Francisco Fed shows just how divergent the economists' expectations have become.





What's unprecedented about this divergence in inflation outlook is that it also shows up in the market. The following chart shows weekly prices for GLD (a gold ETF) and IEF (iShares medium term treasuries ETF) for the last few months. A rally in gold in a normal market should correspond to declines in treasuries. But here we see stability in the treasury market in the face of rising gold prices.





This is an indication of an almost bipolar market that is betting on price stability (even deflation) from credit contraction and continuing unemployment on one hand and accelerating inflation on the other. It's hard to see both occurring, simply because slow economic growth (or further contraction) in the US can not sustain significant price appreciation due to weak demand. Over time something has to give - either commodities have to sell off or longer term rates have to come up.

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Did "hedge everything" policy push Goldman into a bad deal?

Ed Grebeck, CEO of Tempus Advisors had an interesting story to share that may be pertinent to the recent Sober Look post on the Goldman - Buffett transaction:

1999: gold price declining and volatile. GS approached me [Employers Re., a subsidiary of GE capital] with a transaction to hedge their exposure to 3 gold mines [These firms had sold gold forward to Goldman to hedge their gold production]: Ashanti [Ghana; largely owned by Anglo-American], one in Indonesia [previously part of OK Tedi Gold/copper mine] and another in Southeast Asia that escapes my memory. One of the three was fringe BBB/BB. Other two were solid B. These firms also had significant "emerging market" credit issues all around, and CDS in such markets would've cost mega bps.

Trying to address the counterparty risk on the forward contracts, GS came up with a solution: number crunch "joint probability of default" into synthetic (structured finance) tranche exposure. "We want you to sell protection on MEZZ TRANCHE... which as you can see from our painstakingly researched model is... solid BBB"... our pricing is "standard for BBB, plus [small, almost infinitesimal] premium".

Goldman wanted to buy protection on these firms, but to make it cheaper, wanted protection for losses above a certain level on the portfolio of the three names (a mezz tranche CDS). And they were pricing it based on where standard BBB levels were at the time.

Ed Grebeck continues:

No serious mention of "liquidity... hedging ourselves"... other than "we [GS] don't mind if you reinsure yourself ... of course, we can help YOU hedge in cap mkts".

I rejected outright -- but I'm sure other P&C Re "convergence operations"... AIGFP (as well as other competitive silos within AIG), Swiss Re, Munich Re, names not in business today-- ACEFS, St. Paul Re, Gerling Global, Centre etc etc ... jumped at chance to "write premium for GS".

IF GS risk management went berserk 1999 over relatively small counterparty exposure to physical gold producers, imagine what they must have thought in the summer of 2008, when they saw HUGE, UNCOLLATERALIZED exposure on 10 year + S&P index to Berkshire Hathaway

The conclusion here is that with Goldman's focus on hedging all their exposures (based on internal policies), they must have been desperate to get some money out of Buffett to reduce their rapidly rising Berkshire risk (as the puts went deep into the money). It is therefore likely that Buffett was able to pressure Goldman into a transaction that was significantly skewed in his favor - not just because Goldman needed additional equity capital, but because they had to reduce their Berkshire exposure. This in fact provides additional support to a theory that Buffett took Goldman for a ride using his money losing short put positions as negotiating leverage.

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Foreclosures and the unemployment rate maps

This may be "intuitively obvious", but it's worth looking at these two maps next to each other.

Map of home foreclosures:

source: realtytrac


Map of the unemployment rate by state:


source: the Fed

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Ginnie Mae and the government sponsored mortgage machine

A quick look at who is taking all the risk on new mortgages this year reveals some interesting facts. The chart below from the Fed shows some recent trends. Very few mortgage loans are kept on banks' balance sheets these days (Bank Portfolio) - and that fraction seems to be shrinking. The private securitization MBS market (Non-agency securitized) is also down to a trickle, though is a higher fraction than the balance sheet loans.

That leaves the US government to pick up the slack. It's not really a slack, it's the bulk of the new mortgage risk. The majority of these loans are of course extended through Fannie and Freddie. But there is a limit to how much these guys can take. The agencies are financing $5 trillion in U.S. mortgages already. It only takes a slightly higher than normal default rate to become under-capitalized on a $5 trillion balance sheet. The Treasury has so far injected over $100 billion of equity into the agencies to keep them afloat. That caps Fannie's and Freddie's ability to extend more credit.

To keep mortgages flowing however, the government has to pick up the rest directly by providing guarantees and sponsoring government insured MBS issuance. It does it through Ginnie Mae. That's why Ginnie Mae's proportion of newly originated mortgages has exploded.



Source: San Francisco Fed


So what exactly is Ginnie Mae? It's a government agency that actually does not directly take significant mortgage risk. Instead it simply guarantees timely payments on mortgages that are issued or guaranteed by other government agencies. The mortgage pools Ginnie Mae guarantees are:

1. Insured by the Federal Housing Administration,
2. Guaranteed by the Department of Veterans Affairs,
3. Issued or guaranteed by the Department of Agriculture's Rural Housing Service,
4. Issued or guaranteed by the Department of Housing and Urban Development's Office of Public and Indian Housing.

So why the "double guarantee"? Ginnie Mae effectively provides the bridge financing on payments between the time a mortgage loan becomes delinquent and the time when one of the 4 agencies (above) actually makes the investor whole on the guarantee. This way if a mortgage misses a payment, Ginnie Mae makes it immediately, and then collects from the other agencies later. And it does so with a pool of loans that serves as collateral for the Ginnie Mae guaranteed MBS bonds.



source: Ginnie Mae


A Ginnie Mae MBS is effectively a US Treasury security, but issued by a different agency. This shows just how the US government has turned the whole mortgage market into a machine that it now dominates, with a number of it's tentacles participating in different aspects. The Treasury supports the agencies by funding their equity. The Fed buys their debt and the mortgage securities they issue. And to the extent Fannie and Freddie can't handle more lending, the government steps in with four other organizations and wraps up the whole present with the Ginnie Mae guarantee.

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CIT files for bankruptcy and the aftershocks begin

Icahn's attempt to throw out CIT's board in order to take control didn't work. Neither did CIT's effort to exchange debt for equity. The debt holders just didn't buy the story.

Instead, with a $1 billion DIP loan from Icahn, CIT has filed for bankruptcy. The debt holders didn't want to do it voluntarily, and now CIT will try to force the exchange in court. They plan to stuff the current debt holders with new notes (of lower face value) and equity as part of the restructuring plan. But those who owned CIT CDS protection should be happy - they will now get paid out.

CIT claims it will emerge from bankruptcy in a couple of months. But it's unclear their business model is viable at all, even if they reduce their outstanding debt. It is likely the current debt holders will put up a fight to push for a liquidation.

In any case, with debt recovering at 60-70 cents on the dollar, the $2.3 billion of TARP money CIT received as preferred equity is likely gone.

The event has been widely anticipated. The market reaction on Monday will likely be positive as the uncertainty has been somewhat taken out. But the longer-term mess this will create can not be overstated. CIT has liens on hundreds of thousands of businesses via loans the firm had extended. Many of those businesses are stuck because the liens prohibit them from additional indebtedness. That means they can not take out new loans from others (without fully repaying CIT) in their attempt to replace CIT as their lender. The process of replacing CIT will be painful and chaotic, taking it's toll on the middle market companies over the next few years.

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The Berkshire - Goldman OTC derivatives connection

The following story on Berkshire Hathaway's equity derivatives fiasco has been all but forgotten. This is surprising, given the recent push for derivatives regulation. The lack of coverage on this is also surprising, given the last statement in the quote below on counterparty exposure.

The NY Times, May-2008: Berkshire said it had a $1.2 billion pre-tax unrealized loss on put options it wrote on the Standard & Poor's 500 and three foreign stock indexes.

It also reported a $490 million pre-tax unrealized loss on contracts that require payouts if some high-yield bonds default between now and 2013.

The exposure may at first seem odd given that, in his shareholder letter in 2003, Buffett called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

But in his letter this year, Buffett said Berkshire had already been paid for its derivatives contracts, giving it cash to invest, and that "there is no counterparty risk."

That's right, Buffett's firm was shorting long-term puts on equity indices. Berkshire had no counterparty exposure on these positions because they were options sellers, but someone obviously had exposure to them. Long-dated exposure is difficult to obtain in size beyond a year in term via exchange traded options. Plus selling exchange traded options will require a great deal of margin in spite of Berkshire's strong credit. That means these trades must have been over the counter (OTC).

Buffett's hypocritical statement on "financial weapons of mass destruction" must have meant that OTC derivatives are OK as long as someone else is taking the counterparty exposure. The question is who was that counterparty. It had to be a limited number of dealers to keep the trade secret. It also has to be someone who likes to be long long-term volatility, because unwinding this option risk could be costly. One firm that stands out is Goldman. They have been known to build long option positions by transacting with their clients. And they had been willing too pay more for those options than the competition because they were willing to own the risk. It is therefore safe to assume Goldman was in fact a key Berkshire's counterparty on these trades.

Given Berkshire's excellent credit, buying puts from Buffett was a no-brainer in terms of counterparty exposure in 2007. But in the latter part of 2008, Goldman must have been getting uneasy as the puts went deep into the money and Berkshire owed Goldman a rapidly growing amount. In the environment of the time, nobody's failure was off the table.

But then came this transaction:

The WSJ, September 2008: Goldman Sachs Group Inc. said it will get a $5 billion investment from billionaire Warren Buffett's company, marking one of the biggest expressions of confidence in the financial system since the credit crisis intensified early this month.
...
The deal is structured in two parts, giving Berkshire a stream of cash and potential ownership of roughly 10% of Goldman. Berkshire will spend $5 billion on "perpetual" preferred shares of Goldman. These are not convertible into equity but pay a fat 10% dividend.

Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05. At Goldman's roughly $50 billion market value, based on that closing price, exercising those warrants would give Berkshire about a 10% stake in Goldman.

Goldman also will go to the public to raise at least a further $2.5 billion by selling common shares. Once it does, Berkshire's stake -- if it has exercised the warrants -- would fall to about 7%. Goldman will have the right to repurchase the preferred shares at any time for a 10% premium.

The ultimate question here is how the preferred share purchase deal was linked to the massive exposure Goldman now had to Berkshire. In a way, the $5 billion cash injection may constitute a nice "margin posting" to Goldman. Were some of the put positions extinguished as part of the deal? The mass media hasn't really connected the dots on this, and it's not clear why other than to many this is an old story. But it definitely deserves another look.



If the readers have any updates on this topic, please e-mail us at tips@SoberLook.com


hat tip Ed.

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Healthcare costs and the fragile labor market

The cost of healthcare to employers has been rising at a rate of about 9% a year in the past 10 years.



source: The Kaiser Family Foundation Survey


This is an unsustainable rate that drove employment costs to levels that prohibited real wage increases, squeezed margins, and made US corporations far less competitive. This was particularly painful for smaller businesses that generated a large fraction of new job creation. Employers had no choice but to pay, until now. Employers still continue to pay those high healthcare premiums, but mostly at the expense of having far fewer employees.

Th only way they can drive costs down is to lower wages or lay off workers. Lowering wages has had an impact in limited cases, as reality sets in for the unions that employers now have the upper hand. But rising healthcare costs limit corporations' ability to cut wages because employees' share of these costs has also been rising dramatically. The combination of wage cuts and rising insurance premiums is pushing net real earnings to the breaking point. Ultimately, cost cutting comes from job reductions as employers try to survive with fewer employees.

The chart below shows the Bureau of Labor Statistics Employment Cost Index that includes healthcare insurance costs. In spite of rising premiums, the growth in costs has dropped significantly. Employers are trying to squeeze every last drop from existing workers. This allows firms to survive by driving efficiencies, but doesn't help the employment picture.



source: Bloomberg


The thinking is that with costs somewhat under control and inventories low, as orders start to pick up, employment may improve. But the situation is extremely delicate because credit, particularly to smaller business, continues to be tight. One way or another the 9% a year healthcare cost increases must end in order to see any signs of improvements in jobs. It also doesn't take extensive analysis to conclude that in this fragile environment, any government policy that increases employer healthcare costs (whether directly or through taxation) will quickly dash hopes for significant labor market recovery.

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